As Facebook Friends Wall Street, Legal Risks Grow

Facebook recently announced a major status update: it’s going public. On Wednesday, February 1st, the company filed registration papers with the Securities and Exchange Commission (SEC) in what marks the first step in becoming a publicly traded company. If all goes according to the planned timeline, the social networking site will raise at least $5 billion in an initial public offering (IPO) in the spring. The company’s expected valuation between $75 billion to $100 billion dollars would give Facebook a higher market capitalization than many longer-established American companies, including Kraft Foods, Goldman Sachs, and Ford Motor Company. Not a bad haul for a company founded in 2004 in the dorm room of a Harvard “dropout.”

Since the news was first leaked, the financial press has been atwitter over the potential record-shattering size of the IPO. According to the company’s S-1 filing, Facebook recorded revenues of $3.71 billion and a net income of $1 billion in 2011. That’s nothing to poke fun at, but analysts warn that the company’s atmospheric valuation could equate to an unsustainable price to sales ratio in excess of 25, roughly five times higher than Google’s. And while the skeptics may be right, it is important to remember that the site boasts 845 million monthly active users, which is just over 12% of the world’s population. If Facebook can continue to turn those eyeballs into advertising (or FarmVille) revenue, maybe the sky is the limit.

In any event, there will be clear winners from Facebook’s IPO. Mark Zuckerberg, the company’s founder, has an ownership stake estimated to be worth a whopping $28.4 billion, which would make him richer than Google Inc.’s co-founders, Larry Page and Sergey Brin. Mr. Zuckerberg’s co-founders and scores of his employees will become billionaires and millionaires overnight. In a stroke of genius, one artist, who painted murals at the company’s headquarters in 2005, accepted Facebook stock as payment and will cash in to the tune of $200 million. Even the Winklevoss brothers – of “Social Network” fame – are in line for a cool $300 million. With Morgan Stanley in the lead role, the banks will earn millions in underwriting fees. And, of course, the lawyers are getting in on the action: Facebook’s S-1 filing reveals that attorneys from Fenwick & West LLP and Simpson Thacher & Bartlett LLP are taking the lead as advisers in what could be the creation of the world’s largest Internet company.

Yet while there is much to “like” about Facebook’s future outlook, the company may soon face a growing number of legal obstacles. Facebook’s IPO will certainly add to the company’s public profile, which will raise the interest of regulators in Washington, DC, and its competitors in Silicon Valley. In November, the company reached a settlement with the Federal Trade Commission after the agency alleged that Facebook’s privacy policies were misleading customers. Observers of Google’s recent legal troubles with the FTC and DOJ might wonder whether Facebook will be the next dominant company to come under the microscope of the antitrust authorities. Perhaps most concerning is the fact that Facebook has come under attack from competitors and patent aggregators in a growing number of patent lawsuits.

Despite the serious drawbacks to a public listing, Facebook has little choice. An antiquated SEC rule from 1964 requires any private company with more than 500 ”shareholders of record” to follow the same financial disclosure requirements as public companies. So while Facebook technically could have remained private and filed detailed financial reports, it would have borne the costs of close financial scrutiny without any of the benefits. Selling stock to the public and letting the company’s 3,500 employees cash in is also seen as an important strategy in helping Facebook retain its talented workforce.

So what will the company do with all the capital it raises in the spring? Besides vague references to expansion into Asia, the company has indicated that it has no specific plans for the money it raises. If Facebook learns anything from Google’s experience with government regulators in DC and its competitors in Silicon Valley, the company would be wise to set aside a war chest for its future legal battles.

4 Responses to As Facebook Friends Wall Street, Legal Risks Grow

Good points Talor. It would appear Facebook, in anticipation of its impending IPO, is feeling cash rich and snatching up potential future rivals, such as Instagram. Obviously, since Instagram only had 12 employees, it had nowhere near the presence of Facebook, but considering I mostly use Facebook for sharing pictures, I’m not surprised Zuckerberg took this opportunity to snatch up a potential rival photosharing site.

I find it odd that Facebook would decide to go public after eight years, but have no plan for the money it will raise.

I can’t imagine that “expansion into Asia” would require too much funding. I assume that expansion is largely advertising focused (and perhaps hiring some translators). But Facebook’s product advertises itself. People seem to join Facebook because they know other people on it.

From 2007 to 2010 when I was living in Israel, Facebook’s presence exploded. At first few people if anyone had heard of it, and by the time I left it was as popular there as it was in the United States. I attribute its popularity to allowing for other languages. Originally, only my friends who spoke English had accounts, but eventually Facebook allowed for people to write in Hebrew characters (instead of English transliterations).

I am guessing that an expansion to Asia would not be too costly. But then again, China’s #1 search engine is not Google, it is “Baidu” . . . so maybe expansion into Asia is harder than it seems.

Great post Niels. You are right – Facebook should save some of its money for all of the inevitable lawsuits that other people and companies will file against it as a result of the IPO. Facebook had 22 pending lawsuits against it before the IPO, so I hope they use some of the billions they earn through the IPO to invest in better patent protection!